House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 5 - Cost setting rules - additional rules

Outline of chapter

5.1 This chapter explains amendments to the consolidation cost setting rules. The amendments explained in this chapter are contained in Schedules 1, 4, 17 and 21 to this bill.

5.2 This chapter explains the rules for:

•

what happens if there is an error in working out, or in distributing, an entity's ACA when it joins a consolidated group;

•

what happens if the ACA is based on a liability that changes after the joining time; and

•

refinements and enhancements (including technical corrections) to existing cost setting rules.

5.3 This chapter also explains certain consequential amendments to other areas of the income tax law as a result of the cost setting rules.

5.4 All references to sections and divisions are references to sections and Divisions of the ITAA 1997 unless otherwise stated.

Context of reform

5.5 The treatment of assets held by entities that join a consolidated group is based on the asset-based model discussed in A Platform for Consultation and recommended by A Tax System Redesigned .

5.6 This model dispenses entirely with the income tax recognition of separate entities within a consolidated group. It treats a consolidated group's cost of acquiring an entity that becomes a subsidiary member as the cost to the group of acquiring the assets of that entity.

5.7 The majority of the cost setting rules are contained in previous bills and Acts. The following table contains details of the cost setting rules and cross references to the legislative provisions and explanatory memorandum chapters.

Summary of new law

Errors in tax cost setting amounts and changes in liabilities

5.8 The ACA is worked out when an entity joins a consolidated group. It is distributed among the entity's assets to give them a tax value in the group's hands. An error made in working out the ACA would be reflected in each reset cost base asset, so may require extensive re-calculation. To reduce compliance costs, the amendments aim to avoid those re-calculations.

5.9 The ACA is increased by an amount for the joining entity's liabilities. Because some liabilities are estimates of future debts, their amount could change after the entity has joined a consolidated group. If the entity had not joined the group, such a change would be reflected in the capital value of the membership interests in the entity and so affect the owner's taxable income or loss when it disposed of those interests. That does not happen if a consolidated group disposes of the entity because of the way that the cost setting rules apply. Therefore, the amendments ensure that a change in a liability after the joining time is properly brought to account.

5.10 If there is a mistake in working out the tax cost setting amounts for the assets of an entity joining a consolidated group, but it would be unreasonable to have to recalculate the amounts, the incorrect amounts are taken to be correct. The difference is brought to account as a single capital gain or loss when the mistake is discovered.

5.11 If a liability is taken into account in working out the ACA of an entity that joins a consolidated group, and that liability is discharged for a different amount, any difference it would have made to the ACA is a capital gain or loss at the time of discharge.

Refinements and enhancements to cost setting rules

5.12 Refinements and enhancements, some of which have arisen from consultation, are made to the cost setting rules. The amendments relate to the following areas:

•

adjusting the ACA for pre-joining time roll-overs from a foreign resident company to a resident company;

•

adjusting the ACA for distributions of profits that did not accrue to the head company;

•

allocating the ACA in a manner that accounts for direct and indirect membership interests in subsidiary entities;

•

working out the ACA on formation of a consolidated group for subsidiary members other than those electing to retain existing tax values for their assets;

•

allowing certain roll-overs connected with the restructure of a foreign owned group to be excluded from the application of section 701-35 of the IT(TP) Act 1997; and

•

extending a transitional rule for consolidated groups with a SAP and for those groups with an income year ended 30 June.

5.13 A number of technical corrections are also made to the cost setting rules.

Consequential amendments

5.14 The new SIS, introduced following the consolidation rules, changed the basis for recording a corporate tax entity's franking account from a taxed income basis to a tax-paid basis. Broadly speaking, the SIS commenced on 1 July 2002. The cost setting rules currently refer to the old imputation provisions contained in the ITAA 1936. The amendments contained in this bill amend the ACA calculation to reflect appropriate interactions with the SIS.

5.15 The cost setting rules in certain circumstances give rise to a capital gain or a capital loss for the head company of a consolidated or MEC group. Amendments are made to allow the head company to recognise that capital gain or a capital loss.

Detailed explanation of new law

5.16 The amendments explained in this chapter are discussed under the following topics:

•

adjusting for tax cost setting errors (see paragraphs 5.17 to 5.34);

•

what if the amount of a liability changes when realised (see paragraphs 5.35 to 5.42); and

•

refinements and enhancements (including technical corrections) to existing cost setting rules (see paragraphs 5.43 to 5.102)

Errors in tax cost setting amounts and changes in liabilities

Adjusting for tax cost setting errors

5.17 When an entity joins a consolidated group, it has to work out its ACA. That is, a global amount that is distributed among the entity's assets to set their value for tax purposes (their 'tax cost setting amount') in the hands of the group. Occasionally, a mistake will be made in working out, or distributing, the ACA. In some of those cases, it would not be reasonable to have to go back and work out the correct tax cost setting amounts. The amendments ensure that, in those cases, the incorrect amounts are taken to be correct and the differences in ACA caused by the error are instead brought to account as a single capital gain or loss.

5.18 This outcome is intended to reduce the compliance costs involved in re-calculating the correct tax cost setting amounts [Schedule 4, item 2, section 705-305] . In achieving that purpose, it accepts that there may be differences in the nature of the amounts and in the times at which they are brought to account for tax purposes.

When are incorrect tax cost setting amounts preserved?

5.19 Incorrect tax cost setting amounts will be preserved if these 4 conditions are satisfied:

•

the head company took into account a tax cost setting amount for a reset cost base asset of the joining entity [Schedule 4, item 2, subsection 705-315(2)] ;

•

the tax cost setting amount was wrong because the head company made an error in working it out [Schedule 4, item 2, subsection 705-315(3)] ;

•

the error was not due to fraud or evasion [Schedule 4, item 2, subsection 705-315(5)] ; and

•

it would be unreasonable to require the amounts to be re-calculated having regard to the total size of the net errors relative to the ACA, the number of tax cost setting amounts that would have to be re-calculated, the number of amendments needed to correct the error and the difficulty of getting any necessary information [Schedule 4, item 2, subsection 705-315(4)] .

5.20 The last of those conditions asks whether requiring the taxpayer to re-calculate the correct cost setting amounts would be reasonable in the circumstances . It does not specify exactly when it would, and when it would not, be reasonable; it merely sets out what are the relevant circumstances and requires a judgment to be made. This allows for some flexibility to accommodate differences in the relative importance of those circumstances from case to case.

5.21 In general though, it would become less reasonable to require the tax cost setting amounts to be re-calculated as:

•

the proportion, of the ACA represented by the total error in the amounts, got smaller;

•

the number of tax cost setting amounts that would have to be re-calculated gets larger;

•

the number of adjustments in existing assessments or future tax returns in order to correct the errors gets larger; and

•

it becomes more difficult to obtain the information necessary to perform the re-calculations or make the adjustments.

5.22 The judgment about whether or not it is reasonable to require the correct tax cost setting amounts to be re-calculated may be influenced by the measure's stated object of avoiding the time and expense that would be involved in correcting errors [Schedule 4, item 2, section 705-305] . For example, if there would be little time or expense involved in correcting the errors, it is more likely that it would be reasonable in the circumstances to require the tax cost setting amounts to be re-calculated.

What happens when an error is preserved?

The error is taken to have been correct

5.23 If the 4 conditions mentioned in paragraph 5.19 are satisfied, the erroneous tax cost setting amounts are taken to have been correct for most purposes of the ITAA 1936, the ITAA 1997 and the TAA 1953. [Schedule 4, item 2, subsections 705-315(1) and 705-320(1)]

5.24 That means, for example, that:

•

any change in the gain or loss because of the incorrect tax cost on disposal of those assets will not be adjusted;

•

any change in depreciation of those assets because of the incorrect tax cost will not be adjusted; and

•

the Commissioner cannot amend an assessment to correct those figures or anything else that depended on them.

Example 5.1: ACA error taken to be correct

Satrune Pty Ltd joins the Squalley Group. The ACA was worked out as $6.2 million but, in fact, it should have been $6.5 million. The error was not discovered for some years, at which time the group notified the Commissioner. There was no fraud or evasion, the error was only a small fraction of the ACA and Satrune had a large number of assets when it joined the group, so it is not reasonable to re-calculate the figures or to amend the assessments. Therefore, the tax cost setting amounts based on the incorrect ACA are taken to be correct.

5.25 There are some exceptions to the rule about taking the erroneous figures to be correct. The error is still recognised for these provisions of the TAA 1953:

•

section 8N (offence for making a false or misleading statement);

•

section 284-75 of Schedule 1 (administrative penalty for making a false or misleading statement); and

•

section 284-145 of Schedule 1 (administrative penalty for entering into a scheme to get a tax benefit);

in relation to statements made before the Commissioner became aware of the errors.

[Schedule 4, item 2, subsection 705-320(2)]

5.26 The policy behind the penalties for making false or misleading statements is to encourage taxpayers to be truthful and accurate in the statements they make to the Commissioner. The policy behind the penalty for entering into a scheme to obtain a tax benefits is to discourage taxpayers from entering into such schemes. These exceptions to the rule about taking the erroneous figures to be correct are necessary to preserve those policies.

5.27 The rule about taking the erroneous figures to be correct also does not limit the operation of Part IVA of the ITAA 1936 [Schedule 4, item 2, section 705-310] . That means that a tax benefit from a scheme that alters the tax cost setting amounts could be cancelled by the Commissioner and action taken to give effect to that cancellation.

There is a capital gain or loss

5.28 If the 4 conditions are satisfied, there is also a new CGT event (CGT event L6) for the head company of the consolidated group. [Schedule 4, item 4, subsection 104-525(1)]

5.29 The CGT event happens at the start of the income year that the Commissioner becomes aware of the error. [Schedule 4, item 4, subsection 104-525(2)]

5.30 So long as the Commissioner could otherwise amend all the assessments affected by the error (see paragraphs 5.32 and 5.33 if only some assessments can be amended), there will be:

•

a capital gain equal to the net amount by which all the tax cost setting amounts were overstated (called the net overstated amount ); or

•

a capital loss equal to the net amount by which all the tax cost setting amounts were understated (called the net understated amount ).

[Schedule 4, item 4, subsections 104-525(3) and (4)]

Example 5.2: Capital gain replaces ACA correction

Continuing the previous example, the ACA for Satrune Pty Ltd was understated by $300,000. That led to a net understatement of $300,000 in the tax cost setting amounts of Satrune's reset cost base assets. This might have been made up only of tax cost setting amounts that were understated, or there might have been some overstatements and some understatements. In either case, the result must have been a net understatement of $300,000.

Therefore, the head company in the Squalley Group, Squalley Holdings Pty Ltd, would have a capital loss of $300,000 in the income year that the Commissioner was notified.

5.31 This capital gain or loss aims to bring the total amount of the error to account as a single amount rather than as a series of adjustments to the tax values of the joining entity's assets. The same amount will be brought to account in total but its character and the timing could be different. For example, if the error increases the cost of an item of trading stock, it will be balanced by a capital gain, not a revenue gain. Similarly, an error that decreases the cost of a depreciating asset will be balanced by an immediate capital loss, not one loss each time a deduction is claimed for depreciation. Changes to the character and timing of the balancing amount are inevitable consequences of reducing compliance costs by substituting a single amount for a series of effects on a diverse range of assets.

5.32 If the mistake was only discovered after time limits made it impossible to amend any of the assessments that had been affected by it, then some part of the mistake would become permanent. The amendments do not count these permanent parts of mistakes when working out what lump sum amount is needed to correct them. That is consistent with this measure's policy of achieving the same broad outcome as would be achieved anyway but with reduced compliance costs.

5.33 To prevent counting the permanent parts of the error, only this fraction of the full capital gain or loss is brought to account:

The total tax cost setting amount for reset cost base assets that the head company held from the joining time to the earliest year whose assessment could still be amended when the Commissioner became aware of the error / The total tax cost setting amount for all reset cost base assets held by the joining entity at the joining time


[Schedule 4, item 4, subsections 104-525(5) and (6)]

Example 5.3: When only part of the error is correctable

Suppose in the previous example that Satrune joined the Squalley Group in year 1 and that the Commissioner was notified of the $300,000 error in year 7. In year 2 Satrune had sold for $700,000 a block of land that had been allocated $500,000 of the ACA. All the other assets (all of which were reset cost base assets) were still held into year 3. When he became aware of the error, the Commissioner was still able to amend all assessments from year 3 onwards but not the assessment for year 2. In these circumstances, the $300,000 capital loss for the error will be reduced like this:

300,000 * (5.7 million / 6.2 million) = 275,806


The $6.2 million is the total ACA and the $5.7 million is the ACA distributed to the assets held into year 3 (i.e. excluding the $500,000 allocated to the land sold in year 2). The $275,806 result is the amount of the error that could still be corrected if the correct figures had been calculated and all possible amendments made to assessments. Rather than making all the re-calculations, the Squalley Group will have a $275,806 capital loss in year 7.

Does a head company have to do anything when it discovers the error?

5.34 The head company of a consolidated group must notify the Commissioner in the approved form of an error it made in working out a tax cost setting amount as soon practicable after discovering it. [Schedule 4, item 2, subsection 705-315(6)]

What if the amount of a liability changes when realised?

5.35 In some cases, the ACA will be correct but the actual amount of a liability will turn out to be different from the amount used to work out the ACA at the joining time. This could be for many reasons. Some liabilities (e.g. provisions for insurance claims) are no more than estimates of future payments. Those estimates will seldom be completely accurate. Some liabilities might be wholly or partly forgiven by the creditor after the joining time. Some liabilities will be denominated in a foreign currency and the exchange rate might move after the joining time.

5.36 If the liability figures used at the joining time were wrong (e.g. because the amount was not in accordance with accounting standards), the error rules would apply. But many changes in a liability will not be because the joining time figure was wrong (e.g. the cases mentioned in paragraph 5.35). The error rules will not apply in those cases but the change in the liability can produce a similar effect to an error in the ACA. Therefore, the amendments account for any difference that using the eventual amount of the liability would have made to the ACA.

5.37 They do so by creating a new CGT event (CGT event L7) that will generate a capital gain or loss. [Schedule 4, item 4, subsection 104-530(1)]

5.38 CGT event L7 happens if:

•

a liability that was taken into account in working out the ACA is discharged for a different amount; and

•

had that amount been used at the joining time, the ACA would have been different.

[Schedule 4, item 4, subsection 104-530(3)]

5.39 There is a capital gain if the ACA would have been smaller had the amount for which the liability was discharged been used at the joining time. There is a capital loss if the ACA would have been larger. The amount of the capital gain or loss is equal to the difference that would have been made in the ACA. [Schedule 4, item 4, subsections 104-530(4) and (5)]

5.40 CGT event L7 happens at the start of the income year in which the liability is discharged. [Schedule 4, item 4, subsection 104-530(2)]

Example 5.4: Capital gain on a change in a liability

The Stuhrer Group acquired Trister Insurance Pty Ltd for $130 million in year 2. In year 1, Trister had deducted $100 million, which it had estimated to be the amount it would have to pay out on insurance claims for that year and carried that amount forward as a tax loss.

In year 3, the Stuhrer group consolidated and Trister joined. At that time, Trister had increased its provision for year 1's insurance claims to $150 million because of higher than expected claim lodgments. This produced an ACA of $200 million.

The insurance claims for year 1 were finally satisfied in year 4 for only $80 million. If that figure had been used to work out the ACA at the joining time, the ACA would have been $186 million.

Because the ACA would have been lower, there will be a capital gain in year 4 equal to the $14 million difference (i.e. $200 million - $186 million).

5.41 Not every change in the amount of a liability between the joining time and its discharge will affect the ACA. That is because the ACA calculation factors in future tax effects for the liability and, taking those into account, there may be no net change in the ACA.

Example 5.5: Liability changes but the ACA does not

In the previous example, suppose that the year 1 insurance claims had instead been satisfied for $120 million. If that figure had been used at the joining time, the ACA would have been $200 million (i.e. unchanged from what it was at the joining time). There is no change because the decline in the liability would have been matched by the decline in the tax losses that accrued to the Stuhrer group, resulting in no change to the figure taken into account at step 2 of the ACA calculation.

5.42 The full capital gain or loss for CGT event L7 is brought to account in the income year that the liability is discharged. That is different to the CGT event L6 case (when some of the capital gain or loss might not be brought to account). That different treatment is explained by the different nature of the cases. In the CGT event L6 case (errors in tax cost setting amounts), a mistake was made that might not be fixable because of time limits on amending assessments. In the CGT event L7 case, no error was made in the past; an amount is simply being brought to account in the year the liability was discharged because the amount of the liability has changed. This continues the tax law's usual approach of bringing an amount to account to correct the effect of an estimate when the amount of that correction can be ascertained (e.g. see subsection 170(9) of the ITAA 1936).

Refinements and enhancements to existing cost setting rules

5.43 The changes to the cost setting rules relate to amendments to the following areas:

•

adjusting the ACA for a pre-joining time roll-over from a foreign resident company to a resident company (see paragraphs 5.45 to 5.52);

•

adjusting the ACA for distributions of profits that did not accrue to the head company (see paragraphs 5.53 to 5.60);

•

adjusting the allocation of ACA where subsidiary entities have certain profits or losses (see paragraphs 5.61 to 5.71);

•

working out the ACA on formation of a consolidated group for subsidiary members other than chosen transitional entities (see paragraphs 5.72 to 5.74);

•

allowing certain roll-overs connected with the restructure of a foreign owned group to be excluded from the application of section 701-35 of the IT(TP) Act 1997 (see paragraphs 5.75 to 5.88); and

•

extending the operation of step 3 of working out the ACA on transition for consolidated groups with a SAP and for those groups with an income year ended 30 June (see paragraphs 5.89 to 5.94).

5.44 A number of technical corrections are also made to the cost setting rules (see paragraphs 5.95 to 5.102).

Adjustment to ACA for pre-joining time roll-over from a foreign resident company to a resident company

5.45 One effect of a roll-over of an asset within a wholly-owned group is a deferral of any gain that would otherwise be brought to account as a result of the disposal. The taxation of this gain is deferred until the asset leaves the group because either it is disposed of directly or it leaves with the disposal of an entity. The deferral takes place by allowing the recipient company to retain the originating company's cost base for the asset. An effect that can occur where the originating company in a roll-over is a foreign resident company is that the group's aggregate cost for its assets following consolidation would be different from what it would have been if the roll-over had not occurred. The purpose of this provision is to offset any effect that a roll-over would otherwise have in altering a group's aggregate cost for its assets.

5.46 An additional step, step 3A, is included in determining the joined group's ACA for a joining entity [Schedule 1, item 11, section 705-60, item 3A in the table] . This step applies in limited circumstances where:

•

before the joining time there was a roll-over of a CGT asset under Subdivision 126-B, or section 160ZZO of the ITAA 1936;

•

the originating company of the roll-over was a foreign resident and the recipient company was an Australian resident that did not become the head company of the joined group;

•

there was not a CGT event, other than another roll-over, in relation to the asset between the roll-over time and the joining time;

•

the CGT asset is not a pre-CGT asset at the joining time; and

•

the entity that holds the asset subsequently becomes a member of the joined group where that entity was the recipient of the asset or received the asset as a result of a further roll-over.

[Schedule 1, item 14, subsection 705-93(1)]

5.47 Where step 3A applies the ACA for the joining entity is:

•

increased by the amount of the capital loss that was disregarded as a result of the roll-over (the increase amount); or

•

reduced by the amount of the capital gain that was disregarded as a result of the roll-over (the reduction amount).

[Schedule 1, item 14, subsection 705-93(2)]

5.48 Where section 705-93 applies to one or more roll-over assets the result after step 3 in working out the ACA is increased or reduced by the net result taking into account all reduction amounts and increase amounts. If the result after step 3A is negative the head company makes a capital gain equal to the negative amount and the ACA for the entity is nil. New CGT even L2 gives rise to the capital gain.

5.49 When a group comes into existence and an asset has been rolled over to the entity from the head company prior to the formation time section 705-150 applies. That section operates in conjunction with step 3A and the net result after the operation of both provisions applies to determine whether the result after step 3A is negative.

5.50 Sections 705-147 and 705-227 ensure that section 705-93 applies correctly when a consolidated group is formed and where linked entities join a consolidated group. These sections modify the operation of section 705-93 so that it also applies to a roll-over asset held by an entity being a membership interest in another entity that becomes a subsidiary member of the consolidated group at the same time. Where a membership interest is a pre-CGT asset it is not excluded from the operation of these sections. The pre-CGT status of membership interest is retained by the pre-CGT factor attached to the underlying assets of the entity. [Schedule 1, items 15 and 22, subsections 705-147(3) and 705-227(3)]

5.51 Sections 705-147 and 705-227 also require that the step 3A adjustment be made to the ACA for the entity that the head company holds direct membership interests in (the first level entity) where that entity holds direct or indirect membership interests in the entity with the roll-over asset (the subject entity). Where a number of first level entities hold direct or indirect membership interests in the subject entity the step 3A adjustment is apportioned between the first level entities on the basis of the respective market values of their direct and indirect membership interests in the subject entity. [Schedule 1, items 15 and 22, subsections 705-147(2) and (5) and 705-227(2) and (5)]

5.52 As a result of the inclusion of step 3A a number of consequential amendments are necessary to ensure that:

•

step 4 follows step 3A [Schedule 1, item 12] ; and

•

section 705-150 applies to the result of step 3A [Schedule 1, items 16 to 20, section 705-150] .

Adjusting the ACA for distribution of profits not accruing to the head company

5.53 Existing sections 705-155 and 705-230 modify step 4 of the ACA calculation to prevent a duplication of reductions in the ACA for distributions that are effectively a return of the costs of acquiring membership interests. This duplication can occur if reductions are made separately for the distribution of the same profits through a chain of 2 or more entities.

5.54 The existing provisions prevent the duplication by only deducting at step 4 the distribution made by the lowest entity in a chain of companies and not deducting at step 4 distributions made by entities that have successively passed on the distribution. This does not achieve the correct outcome as the distribution may not have been received by the head company.

5.55 Under the cost setting rules for the formation of a consolidated group and where linked entities join an existing consolidated group it is only the cost of the direct interests in a subsidiary member that is pushed down to assets of the subsidiary member (including an asset consisting of membership interests in a lower level subsidiary member). Accordingly, it is only where some of the cost of acquiring the direct membership interests held by the head company in subsidiary members has been returned that the reduction should be made at step 4.

Reduction under step 4 only for distributions that have been made to the head company in respect of direct membership interests

5.56 Existing sections 705-155 and 705-160 have been replaced with amended provisions which ensure that the step 4 reduction in the ACA calculation is only made if the distribution is made in respect of the direct membership interests held by the head company. That is, notwithstanding that the profits may have been distributed to the head company through a chain of entities the reduction in step 4 of the ACA calculation is only made in working out the ACA for the entity that distributes the profits to the head company. [Schedule 1, items 1 and 2, subsections 705-155(2) and (3) and section 705-230]

Reduction under step 4 for effective distribution to the head company

5.57 The amended section 705-155 also ensures that there is a reduction under step 4 in particular circumstances where profits have effectively been returned to the head company. This could occur where:

•

a distribution (called the subject distribution) is made by an entity (called the subject entity) that becomes a member of a consolidated group;

•

the head company of the consolidated group has a direct membership interest in the subject entity at the joining time;

•

the head company acquired the interest in the subject entity, either directly or indirectly, as a result of one or more acquisitions from other entities for which roll-over relief was obtained; and

•

while the head company held the interest, the entity from which it acquired the interest received a distribution (called a further distribution) of some of the subject distribution from the subject entity.

[Schedule 1, item 1, subsection 705-155(4)]

5.58 Where the conditions in paragraph 5.57 are satisfied then there are 2 potential consequences. Firstly, if the following conditions are satisfied:

•

by the formation time, any of the further distribution (called the eligible reduction amount) had not been passed on by the recipient of the further distribution and that recipient does not become a member of the consolidated group;

•

by the formation time, any of the further distribution (called the eligible reduction amount) had been subsequently distributed by the recipient of the further distribution to another entity (including successive distributions) and that other entity does not become a member of the consolidated group; or

•

both the above situations apply,

then in working out the ACA for the subject entity, the reduction under step 4 for the subject distribution only occurs to the extent of the sum of the eligible reduction amounts.

[Schedule 1, item 1, subsection 705-155(5)]

5.59 However, if subsection 160ZK(5) of the ITAA 1936 or subsection 110-55(7) have applied to reduce the reduced cost base of the membership interests in the subject entity, then for the purposes of step 1 of the ACA calculation (i.e. working out the cost of membership interests) for the subject entity the reduced cost base of the membership interests is increased by the reduction previously made. [Schedule 1, item 1, subsection 705-155(6)]

5.60 An amendment is not required to section 705-230 to deal with effective distributions to the head company as the necessary roll-over relief (for the special case to arise) would not be available in the case of linked entities joining an existing consolidated group.

Adjusting the allocation of ACA where subsidiary entities have certain profits or losses

5.61 Sections 705-160 and 705-235, which adjust the market values of interests in entities that have step 5 amounts (i.e. losses that accrued to the joined group before joining time) on formation or when linked entities join an existing consolidated group, are amended to also adjust the market values of:

•

indirect interests in entities that have step 5 amounts; and

•

direct and indirect interests in entities that have step 3 amounts (i.e. undistributed, taxed profits that accrued to the joined group before joining time).

5.62 Extending the scope of these sections in this manner leaves their purpose unchanged as they continue to prevent a distortion in the allocation of ACA under section 705-35. However, these amendments recognise that a distortion occurs when an entity has direct or indirect membership interests in another entity and that entity has certain losses or profits. [Schedule 1, items 9 and 10, subsections 705-160(1) and 705-235(1)]

5.63 As noted in paragraph 1.71 of the explanatory memorandum to the June Consolidation Act, the market value of an entity's membership interests in another entity is increased where the other entity has certain losses in order to avoid the unintended double counting of those losses. Similarly, the market value of those membership interests should be reduced where the other entity has certain profits in order to avoid the unintended double counting of those profits.

5.64 Sections 705-160 and 705-235 operate to adjust the market values of the membership interests in entities that have a 'profit/loss adjustment amount', being step 3 and/or step 5 amounts (as per section 705-60) that are reflected in that entity's ACA calculation. The need for this adjustment only arises when more than one entity becomes a subsidiary member of a consolidated group at the one time.

5.65 Working out an entity's interest in the 'profit/loss adjustment amount' and how it affects the market value of that entity for ACA allocation purposes is dealt with separately depending on whether those interests are:

•

directly held in the entity with the 'profit/loss adjustment amount'; or

•

indirectly held in that entity.

Directly held interests in an entity with step 3 profits or step 5 losses

5.66 This rule applies where there are directly held interests in an entity and those directly held interests are held by a subsidiary of the head company. Accordingly, the rule directs its focus to 2 tiers of entities - a subsidiary that holds membership interests in another subsidiary with step 3 profits or step 5 losses (the 'first entity') and the subsidiary with those profits or losses (the 'second entity'). [Schedule 1, items 9 and 10, paragraphs 705-160(2)(a) and (b) and 705-235(2)(a)]

5.67 The tax cost setting amount for assets held by the first entity is worked out as if the market value of its membership interests in the second entity is:

•

reduced by the first entity's interest in the amount that is added at step 3 when calculating the group's ACA for the second entity - that amount being the second entity's profit/loss adjustment amount; or

•

increased by the first entity's interest in the amount that is subtracted at step 5 when calculating the group's ACA for the second entity - that amount also being the second entity's profit/loss adjustment amount.

[Schedule 1, items 9 and 10, subsections 705-160(2) and 705-235(2)]

5.68 The first entity's interest in the second entity's profit/loss adjustment amount is worked out as follows:

(Market value of first entity's membership interests in second entity / Market value of all membership interests in second entity) * Second entity's profit and-or loss adjustment amount


[Schedule 1, items 9 and 10, subsections 705-160(3) and 705-235(3)]

Indirectly held interests in an entity with step 3 profits or step 5 losses

5.69 The same principle applies where there are indirectly held interests, except that 3 tiers of subsidiary entities are recognised:

•

a subsidiary that has step 3 profits or step 5 losses (the 'third entity');

•

a subsidiary that holds indirectly, through one or more interposed entities, membership interests in the third entity (the 'first entity'); and

•

a subsidiary of the first entity that either directly, or indirectly through a chain of one or more subsidiaries, holds membership interests in the third entity (the 'second entity').

[Schedule 1, items 9 and 10, paragraphs 705-160(4)(a), (b) and (c) and 705-235(4)(a) and (b)]

5.70 When this rule applies, the tax cost setting amount for assets held by the first entity is worked out as if the market value of its membership interests in the second entity is:

•

reduced by the first entity's interest in the amount that is added at step 3 when calculating the group's ACA for the third entity - that amount being the third entity's profit/loss adjustment amount; or

•

increased by the first entity's interest in the amount that is subtracted at step 5 when calculating the group's ACA for the third entity - that amount also being the third entity's profit/loss adjustment amount.

[Schedule 1, items 9 and 10, subsections 705-160(4) and 705-235(4)]

5.71 The first entity's interest in the third entity's profit/loss adjustment amount is worked out as follows:

(Market value of first entity's membership interests in third entity held through second entity / Market value of all membership interests in third entity) * Third entity's profit and-or loss adjustment amount


The numerator above refers to the market value of all of the membership interests that the first entity indirectly holds in the third entity as a consequence of holding membership interests in the second entity. [Schedule 1, items 9 and 10, subsections 705-160(5) and 705-235(5)]

Example 5.6: Accounting for direct and indirect interests in subsidiaries with step 3 profits and step 5 losses in a formation case

Scenario

At the formation time -

SubOne has 2 assets: land with a market value of $500 and 100% of the interests in SubTwo. An ACA of $2,500 is assumed to be available to be allocated.

SubTwo has 3 assets: cash of $70 (a dividend from ProfitSub), 50% of the interests in LossSub and 100% of the interests in ProfitSub. SubTwo has a step 3 amount of $70.

LossSub has only one asset, a depreciating asset with a terminating value and market value of $1,800. It has no liabilities and the market value of the future tax benefit is, in this example, considered to be nil. LossSub has a step 5 amount of $200.

ProfitSub holds land with a terminating value and market value of $1,000. Prior to the formation of the HeadCo consolidated group, ProfitSub earned accounting profit of $140 - being rental revenue of $200 cash less income tax expense of $60. ProfitSub distributed $70 of this profit (franked to 100%) to SubTwo. ProfitSub has a step 3 amount of $70.

Working out the tax cost setting amounts for SubOne

To apply section 705-35, the market value of SubOne's shareholding in SubTwo is $2,040, which is adjusted to $2,000 and calculated as follows:

•

$2,040;

•

less $70, which is SubOne's 100% interest in the 'second entity's profit/loss adjustment amount' for the step 3 profit amount (as per subsections 705-160(2) and (3));

•

less $70, which is SubOne's 100% interest in the 'third entity's profit/loss adjustment amount' for the step 3 profit amount (as per subsections 705-160(4) and (5));

•

plus $100, which is SubOne's 50% interest in the 'third entity's profit/loss adjustment amount' for the step 5 loss amount (as per subsections 705-160(4) and (5)).

SubOne's assets have the following tax cost setting amounts:

Asset	Tax cost setting amount	Workings (under section 705-35)
Land	$ 500	Market value of $500 / total market values of $2,500 * ACA of $2,500
Membership interest in SubTwo	$ 2,000	Market value of $2,000 / total market values of $2,500 * ACA of $2,500
Total ACA	$ 2,500

Working out the tax cost setting amounts for SubTwo

The ACA for SubTwo is $2,070; SubOne's tax cost setting amount for membership interests in SubTwo ($2,000, as per step 1) plus SubTwo's undistributed, taxed profits ($70, as per step 3).

To apply section 705-35, the market value of SubTwo's shareholding in ProfitSub is $1,070 and LossSub is $900.

The shareholding in ProfitSub would have an adjusted market value of $1,000 calculated as follows:

•

$1,070;

•

less $70, which is SubOne's 100% interest in the 'second entity's profit/loss adjustment amount' for the step 3 profit amount (as per subsections 705-160(2) and (3)).

The shareholding in LossSub would have an adjusted market value of $1,000 calculated as follows:

•

$900;

•

plus $100, which is SubOne's 50% interest in the 'second entity's profit/loss adjustment amount' for the step 5 loss amount (as per subsections 705-160(2) and (3)).

SubTwo's assets have the following tax cost setting amounts:

Asset	Tax cost setting amount	Workings (under section 705-35)
Cash	$ 70	After allocating ACA to cash, only $2,000 remains available
Membership interest in ProfitSub	$ 1,000	Market value of $1,000 / total market values of $2,000 * ACA of $2,000
Membership interest in LossSub	$ 1,000	Market value of $1,000 / total market values of $2,000 * ACA of $2,000
Total ACA	$ 2,070

Working out the tax cost setting amounts for ProfitSub

The ACA for ProfitSub is $1,130; SubTwo's tax cost setting amount for membership interests in ProfitSub ($1,000, as per step 1) plus ProfitSub's income tax liability ($60, as per step 2) plus ProfitSub's undistributed, taxed profits ($70, as per step 3).

ProfitSub's assets have the following tax cost setting amounts:

Asset	Tax cost setting amount	Workings (under section 705-35)
Cash	$ 130	After allocating ACA to cash, only $1,000 remains available
Land	$ 1,000	ProfitSub's only other asset
Total ACA	$ 1,130

Working out the tax cost setting amounts for LossSub

The ACA for LossSub is $1,800; SubTwo's tax cost setting amount for membership interests in LossSub ($1,000, as per step 1) plus HeadCo's cost base of membership interests in LossSub ($1,000, as per step 1) less LossSub's accrued losses ($200, as per step 3).

LossSub's depreciating asset has a tax cost setting amount of $1,800.

Working out the ACA on formation of a consolidated group for subsidiary members other than chosen transitional entities

5.72 Existing section 701-20 of the IT(TP) Act 1997 sets out how the ACA is worked out when the head company of a transitional group elects for a transitional entity to be a chosen transitional entity (i.e. to retain existing tax values for the entity's assets). These rules treat the chosen transitional entity as a head company in relation to the membership interests it holds in other entities.

5.73 Paragraph 701-20(5)(c) is amended to make it clear that in applying section 701-20 the membership interests held by each sub-group entity at the formation time were the only membership interests held in any other sub-group member and the membership interests actually held by a sub-group in another sub-group entity prior to that time were the membership interests actually held. [Schedule 1, items 28 and 29, paragraph 701-20(5)(c)]

5.74 The following example demonstrates how the ACA is worked out for a non-chosen subsidiary member.

Example 5.7

Scenario

On 1 July 1999 A Co acquires 60 of the 100 shares in B Co for $60 and B Co accrues undistributed taxed profits of $50 during the year ended 30 June 2000.

On 1 July 2000 A Co acquires a further 30 shares in B Co from the previous holder for $45 (30% of $150) and in that income year B Co accrues a further $100 of undistributed taxed profits.

During the year ended 30 June 2002 HeadCo acquires all of the shares in A Co and the remaining 10 shares in B Co for $25 (10% of $250) and B Co earns no profits.

HeadCo consolidates on 1 July 2002 and chooses that A Co be a chosen transitional entity.

Calculating the ACA for B Co

Step 1 (applying section 705-65 and subsection 705-140(1))

HeadCo's membership interests in B Co - 105

A Co's membership interests in B Co - 25 - 130

Head company's adjusted allocable amount (applying subsection 701-20(4))

There are no step 2 to step 7 amounts - nil

Sub-group's notional ACA

Applying paragraph 701-20(5)(c)

As the only membership interests that any entity held in B Co at any time were the sub-group's membership interests then the amount of the profit that accrued to the sub-group during the year ended 30 June 2000 is the $50 profit multiplied by 60 and divided by 90 which equals $33.33 and for the year ended 30 June 2001 is the $100 times 90 divided by 90 which equals $100.

Applying paragraph 701-20(5)(d)

The formula is applied as follows:

(90 / 100) * 133.33 = 120


Steps 2-7 sub-group's notional ACA - 120

Total ACA - 250

Exclusion from section 701-35 of the IT(TP) Act 1997

5.75 Where a consolidated group is formed, the cost setting rules apply to set the head company's cost of acquiring the assets of each entity that becomes a subsidiary member of the group at the formation time. Where the group came into existence prior to 1 July 2004, special rules apply in some instances under section 701-35 of the IT(TP) Act 1997 to alter the amount that would otherwise have been the head company's cost of acquiring the assets of a formation member.

5.76 Section 701-35 of the IT(TP) Act 1997 is intended to ensure the revenue is not adversely impacted by groups seeking to maximise choices available under the cost setting rules upon the formation of a group by rolling over assets prior to consolidating. Where the section applies, the cost setting rules operate as if the transfer of the asset had not occurred.

5.77 Broadly, the rules in section 701-35 can be triggered if a CGT event has happened in relation to an asset for which there has been a roll-over under either Subdivision 126-B or section 40-340 prior to a group consolidating and the amount that would be the cost of that asset, or any other asset, to the head company differs as a result of that roll-over.

5.78 The rules contained in section 701-35 of the IT(TP) Act 1997 currently give rise to unintended consequences when applied to foreign owned group restructures as they may prevent the cost of assets in a restructured entity from being reset under the cost setting rules. A foreign owned group may wish to restructure an entity, such as an eligible tier-1 company or a transitional foreign-held subsidiary, prior to consolidating in order to allow the cost of the assets in the entity to be reset.

5.79 A failure to reset the cost of assets in these circumstances could result in the group being taxed on non-existent gains upon a subsequent exit of an entity from the group. A similar problem does not arise for Australian owned groups as it is not necessary for those groups to restructure entities prior to consolidating in order to allow the cost of assets in a restructured entity to be reset.

5.80 To prevent these unintended consequences arising, Schedule 17 to this bill contains rules which are designed to allow certain roll-overs connected with the restructure of a foreign owned group to be excluded from the application of section 701-35 [Schedule 17, item 2, subsection 701-35(3)] . Excluding these roll-overs will allow foreign owned groups to reset the cost of assets in a restructured entity under the cost setting rules upon the formation of a consolidated group or MEC group.

When will the exclusion apply?

5.81 The exclusion from section 701-35 of the IT(TP) Act 1997 will apply where the 4 tests discussed in paragraphs 5.82 to 5.88 are satisfied.

The roll-over asset

5.82 The exclusion will only apply in relation to a roll-over of an asset that is a membership interest in an entity (for ease called the test entity ). [Schedule 17, item 2, paragraph 701-35(3)(a)]

The originating company and the recipient company in the roll-over

5.83 The exclusion will only apply where the originating company in the roll-over is a foreign resident company and the recipient company is an Australian resident company. This requirement is consistent with the objective of the exclusion, which is to allow the cost of assets in the test entity to be reset. As the cost of assets can only be reset where an entity becomes wholly-owned by Australian resident entities, the exclusion will be limited to transfers from a foreign resident company to an Australian resident company. [Schedule 17, item 2, paragraph 701-35(3)(b)]

Test entity must become a subsidiary member upon formation of the group

5.84 The exclusion will only apply where the test entity becomes a subsidiary member, at the time of formation, of a consolidated group or MEC group that qualifies as a transitional group [Schedule 17, item 2, paragraph 701-35(3)(c)] .

5.85 What constitutes a transitional group is defined in section 701-1 of the IT(TP) Act 1997. Broadly, a transitional group is a consolidated group or MEC group that forms during the period beginning on 1 July 2002 and ending on 30 June 2004 and which contains at least one entity that qualifies as a transitional entity. An entity will broadly qualify as a transitional entity if it became wholly-owned by the head company prior to 1 July 2003 and remained owned in that manner until the time of the formation of the group.

Type of subsidiary member

5.86 The exclusion will only apply if, at the time the consolidated group or MEC group is formed, the test entity is not a subsidiary member that:

•

has some of its membership interests held by a foreign resident company or a non-resident trust - called a transitional foreign-held subsidiary; or

•

is an eligible tier-1 company of a MEC group.

[Schedule 17, items 2 and 3, paragraph 701-35(3)(c) and section 719-163]

5.87 If the test entity was one of those subsidiary members, the cost setting rules would not apply to reset the cost of the assets in the test entity at the time of the formation of the group. This requirement therefore ensures that the exclusion will only apply in circumstances where the cost setting rules can apply to reset the cost of the assets in the test entity.

5.88 Without this requirement, the exclusion would be too wide as it would allow the effect of the provision to be circumvented in cases where the cost of the assets in the test entity are not being reset. This would occur, for instance, where the test entity, and one or more entities who hold the rolled-over membership interests in the test entity, are not members of the same transitional group.

Example 5.8

Assume the following structure existed at 16 May 2002:

Assume the group wishes to form a MEC group with effect from 1 December 2002. However, rather than form the group in the structure illustrated with A Co, B Co and C Co as eligible tier-1 companies, the group wishes to restructure prior to the formation of the group to allow the cost setting rules to apply to reset the cost of the assets in C Co. To achieve this, the group undertake the following restructure in relation to C Co:

•

B Co transfers its 80% interest in C Co to D Co with roll-over under Subdivision 126-B applying in relation to the transfer; and

•

Top Co subsequently transfers its 20% interest in C Co to D Co with roll-over under Subdivision 126-B again applying in relation to the transfer.

Section 701-35 of the IT(TP) Act 1997 will not apply in relation to the roll-over of the 20% interest Top Co held in C Co, the test entity, as the 4 tests discussed in paragraphs 5.82 to 5.88 have been satisfied in relation to that roll-over. Therefore, to determine whether section 701-35 applies to alter the amount that would otherwise have been the head company's cost of acquiring the assets in C Co, the comparison is to be made between:

•

the amount that would be the head company's cost base for each asset in C Co worked out on the basis that D Co holds 100% of the membership interests in C Co; and

•

the amount that would be the head company's cost base for each asset in C Co worked out on the basis that D Co holds 20% of the membership interests in C Co and B Co holds the other 80%.

If the cost bases for any of the assets are different, the head company's cost of acquiring the assets in C Co will be worked out on the basis that D Co holds 20% of the membership interests in C Co and B Co holds the other 80%.

Extending the operation of step 3 of working out the ACA on transition

5.89 Section 701-30 of the IT(TP) Act 1997, which allows groups to receive an increase in the ACA for undistributed, untaxed profits accrued to the group is now extended so that, in addition to applying to groups that consolidate before 1 July 2003, it applies:

•

to a group if it consolidates on the first day of its income year commencing after 30 June 2003 and before 1 July 2004 - where the head company of the consolidated group has a SAP; and

•

to a group if it consolidates on 1 July 2003 - where the head company of the consolidated group has an income year ending on 30 June.

[Schedule 1, item 27, subsections 701-30(1) and (2)]

5.90 The significance of consolidating at the start of the income year that commences on 1 July 2003 or after that date but before 1 July 2004 is that this concession is extended to undistributed, untaxed profits accruing to a consolidated group prior to the removal of the grouping rules for that group.

5.91 The transitional concession provides groups with an outcome that could be achieved through the payment of an unfranked dividend to the head company prior to the removal of the inter-corporate dividend rebate. As such, the concession reduces compliance costs by removing the need to distribute, prior to consolidating, profits that would be subject to the inter-corporate dividend rebate.

5.92 The change recognises that, in certain circumstances, consolidated groups with a SAP have access to the inter-corporate dividend rebate for untaxed dividends until the end of their SAP, not 30 June 2003.

5.93 In the case of consolidated groups with an ordinary income year (i.e. ending 30 June), the concession which provides recognition under the cost setting rules for undistributed, untaxed profits accruing prior to the removal of the grouping rules is extended to apply to groups that consolidate on or before 1 July 2003.

5.94 Without the amendment, the concession would only be available to consolidated groups with an ordinary balancing date of 30 June where they consolidate prior to 1 July 2003. This would have required the group to consolidate from 30 June with the additional compliance costs of not consolidating from the first day of their income year.

Technical corrections

5.95 The bill also contains a number of technical corrections.

Technical correction to section 701-45

5.96 The reference in the subsection 701-45(3) to 'head company' is being deleted so that the provision (which sets the cost of the asset encompassing a liability that the head company owes to the leaving entity) instead refers to the income tax consequences of the 'entity'. This will ensure that the objects clause is consistent with the section applying for entity core purposes. [Schedule 1, item 24, subsection 701-45(3)]

Technical correction to section 705-150

5.97 As noted in paragraphs 1.56 to 1.66 in the explanatory memorandum to the June Consolidation Act, section 705-150 adjusts the ACA calculation for a subsidiary member where the head company rolled over an asset to that subsidiary and cost base of the consideration given by the subsidiary for that roll-over did not equal the cost base of the rolled over asset. To correct the effect that the head company roll-over adjustment amount has on the step 3 result, section 705-150 is being amended such that the step 3 result is:

•

increased where the head company roll-over adjustment amount is an excess; and

•

reduced where the head company roll-over adjustment amount is a shortfall.

[Schedule 1, item 26, subsections 705-150(3) and (4)]

Technical correction to section 701-35 of the IT(TP) Act 1997

5.98 Currently, where the conditions outlined in section 701-35 of the IT(TP) Act 1997 are satisfied in relation to a CGT event that happens after 16 May 2002, Part 3-90 applies as if the CGT event did not happen. It has been argued that applying all of Part 3-90 on this assumption may have a wider effect than intended. For instance, it has been argued that the provision may currently prevent an entity from becoming a member of a consolidated group where the asset that was the subject of the CGT event was a membership interest in the entity.

5.99 Section 701-35 of the IT(TP) Act 1997 is intended to ensure certain CGT events are disregarded for the purposes of applying the cost setting rules in Division 705 of the ITAA 1997. Where the conditions for applying the provision are satisfied, the cost setting rules are to apply as if the asset was still with the transferor, and not the transferee, and that any consideration given in relation to the event had not been given.

5.100 To clarify what is the effect of section 701-35 of the IT(TP) Act 1997 applying, a technical amendment is made to that section so that only Division 705 and the provisions of the IT(TP) Act 1997 that modify the effect of that Division, apply on the assumption that the CGT event had not happened [Schedule 17, items 1 and 2, subsections 701-35(1) and 701-35(2)] . This amendment closes off arguments that other Divisions of Part 3-90, such as the membership rules, are to be applied on the assumption that the CGT event had not happened.

Other technical corrections

5.101 Other technical corrections are being made to the cost setting rules in the ITAA 1997. These corrections amend:

•

subsection 701-25(4) (tax neutral consequences) by deleting the comma after the parentheses in order to improve the readability of the subsection [Schedule 1, item 23, subsection 701-25(4)] ; and

•

subparagraph 701-75(3)(a)(ii) to correct the punctuation used and to ensure that the conditions in both paragraphs (a) and (b) are to be satisfied [Schedule 1, item 25, subparagraph 701-75(3)(a)(ii)] .

5.102 Further technical corrections are being made to the IT(TP) Act 1997 to include words identifying that cross references to provisions of the ITAA 1997 are to provisions of that Act and not the IT(TP) Act 1997. [Schedule 1, items 30 to 36, sections 701-5, 701-15, 701-20 and 701-25]

Application and transitional provisions

5.103 These measures will take effect on 1 July 2002, along with other aspects of the consolidation measure.

Consequential amendments

5.104 Consequential amendments are made to the income tax law to account for:

•

errors in tax cost setting amounts and changes in liabilities (see paragraphs 5.105 to 5.111);

•

changes resulting from the SIS (see paragraphs 5.112 to 5.117); and

•

CGT events relating to setting the cost of assets (see paragraphs 5.118 to 5.138).

Errors in tax cost setting amounts and changes in liabilities

Penalty provisions

5.105 Amendments to section 8W, and to sections 284-80 and 284-150 of Schedule 1 to the TAA 1953 are required as a consequence of the measure that preserves errors in tax cost setting amounts. Those sections allow additional penalties to be imposed when the amount of tax payable is reduced because a taxpayer either makes a false or misleading statement or enters into a scheme. The additional penalties are based on the reduction in tax.

5.106 The consequential amendments are needed to create a proxy for that reduction in tax. They start with the amount of the capital gain, so do not apply to cases where the error caused a capital loss. Also, using the capital gain as a starting point automatically excludes the part of the error that can no longer be corrected by amending an assessment (because the capital gain does not include those amounts (see paragraph 5.32)). [Schedule 4, items 8, 9 and 10, subsection 8W(1C) and subsections 284-80(2) and 284-150(3) of Schedule 1 to the TAA 1953]

5.107 The capital gain is then reduced to exclude the part of it that represents future tax effects, on the basis that any future tax effect has not yet produced a reduction in tax. The future tax effects are excluded by removing the part of the capital gain that relates to reset cost base assets still on hand at the start of the income year that the error is discovered. However, any deductions for decline in value already claimed for those assets is added back because those deductions represent existing, not future, tax effects. [Schedule 4, items 8, 9 and 10, subsection 8W(1C) and subsections 284-80(2) and 284-150(3) of Schedule 1 to the TAA 1953]

5.108 These calculations leave, as the proxy for the reduction in tax, the part of the capital gain that relates either:

•

to reset cost base assets that were not still held in the year that the error was discovered but had been held long enough for relevant assessments to still be amendable; or

•

to depreciation deductions for reset cost base assets that were still held in the year the error was discovered.

Example 5.9: Penalty for making a false or misleading statement

A company makes an error in working out the tax cost setting amount for its reset cost base assets when it joins a consolidated group. The error is discovered and a capital gain of $200,000 arises.

The tax cost setting amount for all its reset cost base assets was $5.6 million. Of that, $600,000 was for assets that were disposed of in years whose assessments can no longer be amended. Of the remaining $5 million, $3 million related to assets that were not held in the year that the error was discovered and $2 million to assets that were still held in that year. Depreciation deductions of $500,000 had been claimed on the assets that were still held by the group in that year.

The formula to work out the shortfall amount is:

200,000 * (1 - ((2 million - 500,000) / 5 million)


which works out to be $140,000. That is the part of the $200,000 capital gain that relates to assets the company did not hold in the year the error was discovered and to depreciation deductions claimed on assets it did hold in that year.

Miscellaneous

5.109 Division 705 currently ends with a link note to point out that the next Division is Division 707. The amendments repeal that link note to insert rules about errors in tax cost setting amounts. [Schedule 4, item 1, section 705-245]

5.110 There are some amendments that update CGT guide material to cover the new CGT events the amendments are adding for errors in tax cost setting amounts and changes in liabilities. [Schedule 4, items 3 and 5, sections 104-5 and 110-10]

5.111 The dictionary is amended to include definitions of 2 new terms used by the amendments, 'net overstated amount' and 'net understated amount'. The dictionary entries direct readers to subsection 104-525(3) where the substantive definitions are located. [Schedule 4, items 6 and 7, subsection 995-1(1)]

Simplified imputation system

5.112 Amendments are made to step 3 of the ACA calculation for a joining entity, to reflect appropriate interactions with the SIS. The SIS changed the basis for recording a corporate tax entity's franking account from a taxed income basis to a tax-paid basis. Broadly speaking, the SIS commenced on 1 July 2002.

5.113 The purpose of step 3 in the ACA calculation is to prevent double taxation of profits in a joining entity. Step 3 does this by allowing a consolidated group a cost for retained tax or taxable profits that accrued to membership interests that were held by the consolidated group. This can occur where there is an incremental acquisition of an entity.

5.114 The amount added to the ACA under step 3 is calculated by reference to a notional franking account balance at the joining time. The notional franking account balance takes into account the income tax that will be payable or refundable by the joining entity for the income year that ends immediately before the joining time (see subsection 705-90(4)).

5.115 In order to isolate that portion of the undistributed profits of the joining entity that represents taxed profits, the notional franking account is grossed up using the following formula:

Balance of franking account * ((1 - corporate tax rate) / corporate tax rate)


where:

•

the balance of the franking account takes into account those assumptions outlined in paragraph 5.114; and

•

the corporate tax rate is the rate that is applicable to the joining entity at the joining time.

[Schedule 1, item 4, subsection 705-90(3)]

5.116 The amount of taxed profits worked out using this formula cannot exceed the amount of undistributed profits of the joining entity at the joining time.

5.117 Various amendments are made to reflect that the purpose of step 3 of the ACA calculation is to account for tax paid at the joining entity level. [Schedule 1, items 3, 5 to 8]

CGT events relating to setting the cost of assets

5.118 The application of the ACA calculation when an entity joins or leaves a consolidated group may result in a capital gain or capital loss for the head company. The following CGT events prescribe the conditions under which the capital gain or the capital loss will arise.

Where a negative amount remains after step 3A of the ACA on joining: CGT event L2

5.119 Before a consolidated group forms or a subsidiary joins a group, an asset may have been rolled over to the subsidiary by either members of the group or a foreign entity. The effect of the roll-over is to defer a capital gain that would otherwise be bought to account as a result of disposing of the rolled over asset. Where that asset is brought into a group, the capital gain may be sheltered from tax as a result of the tax cost setting process.

5.120 Step 3A of the ACA calculation offsets any effect that a roll-over would otherwise have in altering a consolidated group's aggregate cost for its assets (see paragraphs 5.45 to 5.52). An additional adjustment, under section 705-150, may be required where a group comes into existence and before the formation time an asset had been rolled over from the head company to a subsidiary member of the group (see paragraphs 1.56 to 1.66 of the explanatory memorandum to the June Consolidation Act).

5.121 After applying step 3A, including any adjustments required under section 705-150, the result of the step may be to reduce the ACA below zero. CGT event L2 will happen in this circumstance [Schedule 21, item 3, subsection 104-505(1)] . The head company will make a capital gain equal to the negative amount [Schedule 21, item 3, subsection 104-505(3)] .

5.122 The time of CGT event L2 is just after the joining entity joins the consolidated group [Schedule 21, item 3, subsection 104-505(2)] . This is to ensure that the capital gain that arises may be included in the head company's tax return.

Where the tax cost setting amount for retained cost base assets exceeds joining ACA amount: CGT event L3

5.123 The head company's costs for 'retained cost base assets' is set equal to the joining entity's cost for those assets (see section 705-25).

5.124 Broadly, a retained cost base asset is:

•

Australian currency;

•

a right to receive a specified amount of Australian currency (other than a right that is marketable security within the meaning of section 70B of the ITAA 1936); or

•

an entitlement that is subject to a prepayment.

5.125 If the total amount to be treated as a head company's cost for retained cost base assets of a joining entity exceeds the joined group's ACA for the joining entity, the head company of the consolidated group will make a capital gain equal to the excess. [Schedule 21, item 3, section 104-510]

5.126 The time of CGT event L3 is just after the joining entity joins the consolidated group [Schedule 21, item 3, subsection 104-510(2)] . This is to ensure that the capital gain that arises may be included in the head company's tax return.

Where there are no reset cost base assets and an excess of ACA on joining: CGT event L4

5.127 A 'reset cost base asset' is any asset that is not a retained cost base asset. The ACA remaining after deducting an amount equal to a head company's set costs for the retained cost base assets of a joining entity is allocated among the reset cost base assets, other than excluded assets. There is a proportionate allocation of the remaining ACA to each of the joining entity's reset cost base assets.

5.128 It may be the case that a joining entity does not have any reset cost base assets. An example of this may be where the joining entity is a shelf company acquired by the group. A shelf company would not have been operating prior to acquisition by the group, so cannot allocate the remaining ACA to goodwill.

5.129 CGT event L4 happens when there is an excess of the ACA and there are no reset cost base assets of the joining entity [Schedule 21, item 3, subsection 104-515(1)] . CGT event L4 will always result in a capital loss.

5.130 The amount of the capital loss is equal to the amount that results after the joined group's ACA is reduced by the total of the payments for the retained cost base assets. [Schedule 21, item 3, subsection 104-515(3)]

5.131 The time of CGT event L4 is just after the entity joins the consolidated group [Schedule 21, item 3, subsection 104-515(2)] . This is to ensure that the capital loss that arises may be included in the head company's tax return.

Where a negative amount remains after step 4 of the ACA for a leaving entity: CGT event L5

5.132 Just before an entity ceases to be a member of a consolidated group, the head company recognises the membership interests in that entity. These membership interests would not be recognised whilst the entity was a member of the group because of the single entity principle, which broadly treats that subsidiary member as part of the head company.

5.133 The cost of membership interests in the leaving entity is determined by working out the 'old group's ACA' for the leaving entity. This amount is determined in 5 steps. Step 4 in determining the old group's ACA is to subtract the amount of the leaving entity's liabilities. CGT event L5 happens when the amount remaining after applying step 4 is negative. [Schedule 21, item 3, subsection 104-520(1)]

5.134 The head company will make a capital gain equal to the negative amount [Schedule 21, item 3, subsection 104-520(3)] . CGT event L5 will always result in a capital gain.

5.135 The time of CGT event L5 is when the entity ceases to be a subsidiary member of the group [Schedule 21, item 3, subsection 104-515(2)] . This is to ensure that the capital gain that arises may be included in the head company's tax return.

Consequential amendments as a result of inserting CGT events

5.136 The note after section 100-15 (overview of steps 1 and 2 of calculating a capital gain or capital loss) is updated to reflect that the concepts of cost base and capital proceeds are not relevant for some CGT events, including the CGT events in Subdivision 104-L. [Schedule 21, item 1]

5.137 The tables in section 104-5 (summary of CGT events) and section 110-10 (rules about cost base not relevant for some CGT events) are amended to highlight the special rules in relation to CGT events L2 to L5. [Schedule 21, items 2 and 4]

5.138 Various notes within Division 705 (tax cost setting amounts for assets where entities join a consolidated group) and Division 711 (tax cost setting amounts for assets where entities leave a consolidated group) are amended to refer to the relevant CGT events. [Schedule 1, items 13 and 21 and Schedule 21, items 5 to 7]